Game Theory, Behavioral Finance, and Investing: Part 5 of 5

In the first four parts of this article, I have discussed a number of well-known behavioral biases that cause investors to make decisions that are, to put it kindly, less than optimal. In this final installment, I summarize how best to avoid these costly traps.

As these blog posts have been published over the past couple of weeks, the issues are much in evidence. Apple (AAPL), long the darling of the market, has lost favor and Groupon (GRPN) seems to be following a relentless downward spiral. Surely many investors in Groupon must be asking themselves how they could possibly have seen the company as a good bet. Apple stock, which was trading at $700 in mid-September, is currently at $544, a decline of 22% in two months. The news that has come out on Apple does not seem sufficient to justify such a broad shift in the market’s consensus as to the long-term value of Apple as a company. And, of course, we have the poster child of behavioral bias: Facebook (FB). How is it possible that the market’s consensus view of the share value of such a widely held company could be almost 50% below its first day closing price of $38? As Warren Buffett is quoted as saying, in the short-term the market is a voting machine and in the long-term the market is a weighing machine. When voting overwhelms weighing, investor psychology is dominating.

Investing With Game Theory and Behavioral Finance in Mind

From the perspective of game theory and behavioral finance, what would be the best steps for investors to take?

Avoid the emotional lure of the ‘the next big thing.’

People seem to be hard-wired to find novelty appealing. Combine novelty with a get-rich-quick scenario, and investors are likely to get hurt. I have mentioned a number of cases in the text above and the list is endless. Solar energy stocks are another recent example. First Solar (FSLR), for example, was at $140 in early 2011 and Goldman Sachs (GS) gave this stock a buy rating and a price target of $190. Today, First Solar trades at $25. Yes, the emotional draw of the narrative for solar power was compelling—still is, in fact. That does not mean that it is a good idea to invest at current prices because we want to believe.

Focus on objective arguments for investing decisions rather than falling into herd behavior.

If your reason for making an investment is that everyone else is doing the same thing, the outcomes are probably not going to be good. It is perfectly natural that we look at friends, work associates, and family for validation of our decisions, but using the ‘wisdom of the crowd’ to choose your investments, means that you are buying after the crowd already has. This leads to buying high and selling low.

Think carefully about the agency issues associated with investing. Are your interests aligned with those of your agents?

Consider whether the people acting as agents on your behalf have interests that conflict with your own. It is important to know who is an advisor and who is a salesman. When the CEO of a company gets an enormous stock option grant, he has an incentive to get the stock price to rise, but it is important to understand that if the price collapses, he does not have the same downside risk as the shareholders. Owning call options on a stock (employee stock options are more generally referred to as call options) gives you a very different risk-reward profile than a typical shareholder. You have a strong incentive to take big risks because your potential for gain is unlimited but your downside risk is fixed when you own call options. Taking bigger risks with the growth of the company increases your upside potential but does not increase your potential worst-case loss.

Similarly, when analysts give a stock a high price target, it is useful to think about their incentives. Analysts are not actually agents working on your behalf because you are not paying them. Think carefully about who is paying the analysts’ salaries and bonuses before you make significant decisions on their advice.

The financial services industry itself is grappling with agency issues in the discussion of who should be bound by a fiduciary standard, i.e. who is legally required to act entirely in a client’s interest and avoid all potential conflicts of interest.

Ask yourself whether you really have the expertise to select investments, as opposed to simply owning the whole market via index funds.

There are people who can make a good argument that they have expertise that allows them to build a portfolio that can out-perform a simple long-term buy-and-hold portfolio of index funds. Even among these people, most would be better off just owning the index fund portfolio. People have a natural tendency to believe that they can ‘beat the system.’ This belief certainly brings many gamblers to Las Vegas and many speculators to the stock market. It is always hard to face up to unpleasant realities, but being honest with yourself about your expertise is one of the most financially important decisions you will ever make.

Envision your future self

The study cited earlier found that looking at age progression images of our current selves motivates higher levels of saving. This may be worth a shot, and there are some free apps that will do this for you (search on aging booth at your app store). If you are lucky enough to live a long time, you will be very grateful to your younger self for making the choice to save and invest carefully. If you have children, they too will be grateful that you have taken the steps needed to be financially secure.

Disclaimer

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services.